Sharp-Elbowed Investors See Potential in the Stodgy World of Municipal Debt

Hedge funds are making a large bet on municipal debt, bringing aggressive tactics to a $3.7 trillion market long known as humdrum.

The strategies include demanding high interest rates in return for financing local governments, buying the debt of struggling municipalities on the cheap, and trying to profit on rising volatility as many mom-and-pop investors who have dominated the municipal-bond market for decades flee amid deepening...